Sunday, June 28, 2015

Have the Saudis miscalculated the impact of lower crude prices on US production?

In 2014 the Saudis could no longer accept the loss of crude oil market share as the North American production levels shot up sharply over a three-year period.
Source: Yardeni Research

The Saudi response was quite rational. Rather than cutting production to support crude oil prices, the Saudis announced that output will remain the same. In private they were planning to actually increase production in order to meet rising domestic demand as well as to regain market share. The idea was to put a squeeze on the high-cost North American oil firms, halting production growth and ultimately getting prices back into a more profitable range. Other OPEC nations reluctantly agreed to play along.
CNN (November, 2014): - One motivation is to squeeze higher-cost producers in North America, including the booming U.S. shale industry that has reshaped the global energy landscape.

It's a move Tony Soprano would be proud of. OPEC is betting lower oil prices will force U.S. producers to throw up the white flag and cut back on production because they won't be able to turn a profit.

"The gauntlet has been thrown down for Western Hemisphere producers like Brazil, Canada and the United States," Bespoke Investment Group wrote in a note to clients on Friday.
Is it working? So far the results have been less than what the Saudis had hoped for. After a bounce from the lows, crude oil has been trading in a relatively tight range, with WTI futures fluctuating around $60/bbl.

Source: barchart

How is this price stability possible when the common wisdom was that oil prices below $70/bbl will force most US producers to close shop and North American production would collapse? After all we've seen a spectacular decline in active oil rig count. The answer has less to do with rigs that have been taken offline and more with the technology that remains. After the inefficient rigs have been shut, US rig count is starting to stabilize.

Source: BH

US crude producers are achieving record efficiency with the remaining equipment. The charts below show new-well oil production per rig.

Source: EIA

From multi-well padding (multiple wells in a single location) to superior drill bits, technology is helping to keep production levels high. Well completion costs and the speed of drilling have improved to levels many thought were not possible.

Source @PlanMaestro

With the inefficient rigs mothballed, the remaining capacity is quite lean. It seems that $60/bbl can now sustain a good portion of current production capacity and even turn a profit.
Platts: - ... [US oil producers] have wrung astonishing efficiencies from their operations in a very short period of time, as the number of days to drill a well keeps contracting while initial well production rates and estimated hydrocarbon recoveries expand.

Also, corporate efficiencies, coupled with cost concessions of around 15%-25% granted by oil services and equipment providers this year, have also lowered well costs and driven up internal return rates in the best plays to the point that operators appear comfortable with the current price environment, even if they privately hope for an eventual return to $80/b oil.
To be sure, there is a significant chance that US production slows in the coming months. Thus far however the results of the recent Saudi efforts to diminish US production have been less than satisfactory.

Source: EIA


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Saturday, June 20, 2015

Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:
Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.
There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research


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Tuesday, June 16, 2015

Reasons behind homebuilder optimism

Yesterday a report from the National Association of Home Builders showed that US homebuilders have turned rather optimistic again. Given the recent weakness in construction spending some have dismissed this survey data.

Recently we did however see some signs of improving homebuilder activity in the markets as lumber futures stabilized in mid-May after months of declines.

Source: barchart

Moreover, homebuilder shares have outperformed the broader market over the last few days.

And today we learned the reason for the renewed builder optimism. They are going to have a busy year as new home construction permits spiked to levels not seen since 2007.

Source: Federal Reserve Bank of St. Louis

Does this mean US families are finally getting mortgages and buying new homes? Not exactly. While demand for new homes continues to gradually improve, it is concentrated in the "luxury" sector (larger and more expensive homes). In general single-family housing as a percentage of the overall homebuilding activity continues to decline.

Source: Federal Reserve Bank of St. Louis

Instead, most of the demand is coming from multifamily housing as the need for rental units continues to increase. This is the sector that has been boosting builder optimism and where we are about to see increased construction activity.

Source: Federal Reserve Bank of St. Louis


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Shedding light on recent bond volatility in the Eurozone

Guest post by Marcello Minenna

Typically the technical details of open market operations of the central banks are not known. The unpredictability prevents in fact opportunistic behaviors of banks and alterations in market microstructure.

The ECB’s Public Sector Purchase Program (PSPP) ignores these principles with the following results:
  • bank lending tends to zero;
  • the interest rate volatility of the Eurozone Sovereign Bonds (EZ govies) has considerably increased;
  • banks have achieved almost 13 billion euros of capital gains in return for their national central banks (NCBs).
The first point is self-explanatory and the evidence can be found in the data published by the ECB in April 2015 ( ); QE at least for now is not loosening the credit crunch.

The second point simply comes from an analysis of the options implied volatility on Bund's futures.

With regards to the estimates of the banks' capital gains, some further considerations are required.

First, the fact that bonds with yields lower than the deposit facility rate are not eligible under the PSPP.

The reason of this floor is to avoid that through the monetary policy there could occur undue fiscal transfers within the system. To explain this let’s consider first what happens in a simplified currency area where we have only one Central Bank and one private bank. The private bank sells a bond to the Central Bank, let’s say at 100 euros, and this bond has a coupon rate of 5%. Hence, by buying the bond the Central Bank receives a coupon of 5 euros. The private bank pours the money cashed (from selling the bond) on its deposit account at the Central Bank and it gains a yield on the money deposited. In order to avoid that the Central Bank would experience a loss obviously the deposit account should pay at most an interest of 5%. Let’s move now to the present situation where interest rates are negative and, hence, we have to fit a little bit the reasoning as follows. The Central Bank buys from the private bank the bond at premium (that is with an implied negative coupon) meaning that the Central bank gets losses due to this investment. On the other side it gets a gain from the negative yield on the deposit account of the private bank (currently -0.20% within the Eurosystem). From the point of view of the Central Bank this game rules out losses as long as the interests it receives on the deposits of the private bank are higher or equal to the implied coupon of the bond purchased. Hence it is clear why the PSPP requires that the eligible Govies should have yields higher or equal to -0.2%.

It is also helpful to understand intuitively where the capital gains of private banks come from.

To this purpose, it has to be observed the evolution of the yields’ term structure of the two major member countries of the Eurozone from the PSPP’s first informal announcement (of the 18 November 2014) and up to the 20 April 2015, date on which their yields have reached their all-time low.

There is no doubt that those who had in their portfolio Eurozone sovereign bonds wouldn’t have had no difficulty in achieving capital gains within of a Eurosystem as redesigned by the QE.

Within the core Eurozone countries since mid-April – that is in an environment of zero (or even negative) rates,  with less and less eligible securities for the PSPP, with vanishing liquidity in the secondary market and with new bullish expectations on inflation – banks could easily push up the term structure of interest rates.

Also because if rates were not risen it would have been more difficult to implement trading strategies that could profit from the reduction in interest rates determined by the NCB's purchases.

And after all the rise in interest rates also met the ECB’s desires since at that time about 25% of the Eurozone Govies was displaying negative rates and was no longer eligible for the PSPP by increasing the risk that the program could run out.

It is the first flash crash and, as expected, after the upward jump followed bearish retracements of the interest rate term structure with higher volatility as it happens in an increasingly less liquid market.

Confirmations of this interpretation of the market behaviors arrive in early June with a second flash crash that exhibits the same pattern.

Following these trading schemes within the Eurosystem, banks have earned almost 13 billion euros; a new phenomenon arises: the QE’s brokerage. Within this scheme of course Germany has done the lion’s share thanks to the higher ECB’s capital key and the fact that Bund yields were the lowest of the member states.

The complex architecture of the QE needed to avoid undue transfers between member countries does not seem to be on the right path.

The QE’s brokerage is recapitalizing the banking system leading Eurozone banks' balance sheets to a scheme in which - for all the duration of the PSPP - Govies will be replaced by other Govies.

Meanwhile the ECB decision to delegate the bonds’ purchases to the NCBs continues that process of nationalization of the public and private debts’ risk, which began with the 1 trillion LTROs of late 2011-early 2012.

In fact LTROs started this process through the nationalization of public debt (i.e.: every banking system took care to buy the government bonds of its own country) and the settlement of inter-bank debts recorded on TARGET2.

In short, the ECB once again becomes a gear of this mechanism that adds centrifugal forces within the Eurosystem in which each member country has to undertakes its own risks.

It is perhaps appropriate to review the PSPP rather than waiting for its end (Autumn 2016) when the banks (once recapitalized through the QE’s brokerage) will probably take care of the real economy.


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Sunday, June 14, 2015

US skills gap becoming more acute

The latest report from Job Openings and Labor Turnover Survey (JOLTS) shows that job openings in the United States are at a 15-year high. By the looks of the chart below, one could conclude that there is no slack in US labor markets. But as we know, that's not yet the case.

Moreover, the NFIB small business survey shows US businesses increasingly struggling to find "quality labor" as the labor force skills gap (discussed here a year ago) becomes acute.

Source: NFIB

The percentage of small businesses with unfilled job openings is now above the pre-recession levels. To be sure, those trying to hire are getting dozens of applications. But the applicants lack the skills businesses are looking for.

Source: NFIB

We can see more evidence of the skills mismatch in the latest US Beveridge curve that shows that the number of unemployed and "marginally attached" workers is much higher for the same number of job openings than prior to the recession.

With all those discouraged workers who had left the labor force, shouldn't all these openings be filled quickly? They are not. That's because those without work are usually not the people businesses are looking for. Prior to the recession a great deal of the unskilled labor was absorbed in housing-related industries such as construction. Didn't finish college? No problem - there is a well-paying construction job waiting for you. But those jobs disappeared with the end of the credit bubble.

One area where the skills gap is especially pronounced is manufacturing. Modern manufacturing often utilizes specialized equipment and various forms of automation that require training and experience. However after years of offshoring, the US has gutted its manufacturing base, creating a large deficit of skilled manufacturing workers. The skills gap therefore is likely to persist for years to come, creating a material drag on economic growth.


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Crunch time for the US coal industry

Coal prices in the US are collapsing. The September Appalachian coal futures contract gave up over 2% on Friday as the industry faces unprecedented challenges.

Source: barchart

One can see the decline in the industry's activity levels by tracking rail shipments of coal. Railcar loadings are now at the lowest level in decades.

Source: Yardeni Research

The industry's woes have been caused by a "perfect storm" of events that wrecked havoc on US coal producers. Here are some of the recent developments:

1. US natural gas production has been on the rise for the last decade, continuing through today in spite of the ongoing reductions in rig count. Prices have declined recently as inventory levels returned to normal after the draw-down during the winter of 2013-14. As a result, power producers are increasingly shifting to natural gas. Here is a recent note from the US Energy Information Administration:
EIA expects a 7% decrease in coal consumption in the electric power sector in 2015, despite a 1% increase in total electric power generation. Lower natural gas prices are the main driver of the decline. Projected low natural gas prices make it more economical to run natural gas-fired generating units at higher utilization rates even in regions of the country (Midwest, South) that typically rely more heavily on coal-fired generation. Increased generation from wind, solar, and biomass is also expected to displace coal-fired generation, as several facilities have been converted from coal-burning facilities.
Source: EIA

2. New EPA regulation, particularly the Mercury and Air Toxics Standards (MATS), is pressuring electricity producers to retire some coal power plants.
PLATTS: - Appalachian Power said this week the cost to upgrade coal-fired units at four power plants in Virginia and West Virginia that were retired in May would have been so high it did not even compile cost estimates for the work.

In a report filed earlier this week with the West Virginia Public Service Commission further explaining why the Clinch River and Glen Lyn power plants in Virginia and the Kanawha River and Philip Sporn power plants in West Virginia were retired, APCo said it "has not performed any detailed cost estimates because the order of magnitude of the costs was so tremendous."
3. Global coal demand has fallen off sharply, driven largely (but not entirely) by China.
The Sydney Morning  Herald: China's coal imports slumped 41 per cent in May from a year earlier to 14.25 million tonnes and were down sharply on April despite industry expectations of a pick-up in seasonal demand, data showed on Monday.

Total imports in the first five months of the year reached 83.26 million tonnes, down 38.2 per cent compared with the previous year, according to preliminary data from China's General Administration of Customs.

May's imports were down 28.6 per cent on April, according to the data, while Reuters calculations showed that imports were down 40.6 per cent compared to May 2014.

Imports normally improve over the northern summer, but analysts said any upturn would be limited despite relatively low inventory levels at thermal power plants, with hydropower likely to meet a large share of the increase in power demand.

"Imports are constantly decreasing compared to last year due to new policies, and the use of new (renewable) energy," said Zheng Nan, an analyst with China's Shenyin Wanguo Securities.

4. To make matters worse for the industry, the state of Wyoming is reviewing the balance sheets of some major coal producers. The law requires coal firms to carry insurance that would provide environmental cleanup resources should the firms fail. But with the latest price pressures, some firms may not qualify for such programs and would be forced to maintain collateral. In the current environment these firms may not have the resources for these new requirements.
Bloomberg: - The Wyoming Department of Environmental Quality’s Land Quality Division is reviewing 2014 financial data from Peabody and Arch to see if they still qualify for a “self-bonding” program that allows coal producers to cheaply insure their clean-up costs in case of bankruptcy, Kimber Wichmann, an economist at the department, said in a phone interview.

Miners that fail to meet certain financial benchmarks must buy instruments that include corporate surety bonds and Treasury bills, or hold enough cash, to cover potential reclamation liabilities. 
“Investors don’t know how to handicap this self-bonding issue,” Ted O’Brien, chief executive officer of Doyle Trading Consultants LLC, said in a phone interview. “Until the companies come out and give Wall Street certainty that they know how to deal with it, I think we’re going to be stuck in this vortex.”
Shares of some large coal producers are hitting record lows.

To be sure, coal will remain a major source of electricity production in the United States. Even if the EIA projection (chart below) is too optimistic on the future of coal usage, the survivors of the "coal crunch" stand to profit handsomely. Moreover, some diversified energy firms are still making money on coal even at these prices. Nevertheless, the industry is undergoing a historic shakeup, which a number of industry participants (particularly those who are highly leveraged) may not survive.

Source: EIA (2015 Annual Energy Outlook)

Many thanks to Greg Merrill for a helpful discussion on the topic.

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Sunday, June 7, 2015

Unprecedented levels of activity in China's equity markets

The speculative fervor in China's equity markets is spreading as the Shanghai Composite hits new multi-year highs on elevated volume. The index easily cleared the 5000 mark after hovering just just above 2000 around six months ago. This rally has been nothing short of spectacular.


Here are some key trends that point to just how heated the market has become.

1. A-share (domestic) trading activity has exploded.

Source: Credit Suisse

2. Weekly account openings have reached new highs. This is a revenue bonanza for China's brokers as many tap the IPO market for themselves (see story).

Source: ‏@vikramreuters

3. P/E ratios are touching historical records as well as valuations are stretched in many instances.

Source: ‏@NickatFP 

4. Margin debt levels are also near record, including as a percentage of market capitalization. Here is margin debt a percentage of the GDP.

Source: @PatrickMcGee_ 

Perhaps the most telling sign of speculative activity is this photo. There isn't much one could say here.

Source: @enlundm @DoubleEagle49

China's public equities market cap is now around $10 trillion (as a comparison, Japan's whole market is half that). That's over 13% of the global equity market capitalization (after being just above 5% some six months ago). Chinese tech firms listed in the US are now running back to China where their shares can get an instant pop in valuations (see story).

While many analysts are calling this a bubble, it's important to point out that bubbles can last for a long time. Unless Beijing interferes - and there is a strong possibility it will - this trend could last for a while. Of course the longer this goes on, the uglier things will get on the way down.


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Saturday, June 6, 2015

Looming rental crisis in the United States

The United States is not building enough homes to meet the nation's housing demand. It's difficult for many to accept this fact given some of the over-building that took place during the housing bubble. However that wave peaked around ten years ago and residential construction had since declined to historically low levels. This unprecedented weakness in construction activity has persisted over the past 6-7 years, with only limited signs of recovery. Here are two data points:

1. Residential construction spending as a fraction of the GDP remains suppressed.

2. Housing starts also remain extremely low, especially considering US population growth.  This market has never recovered after the housing crisis - even to "pre-bubble" levels.

Source: Federal Reserve Bank of St. Louis

Part of the issue of course is the nagging tightness in the mortgage market, as homeownership rate continues to decline.

This is funneling more people into the rental market, rapidly tightening the availability of rentals across the United States.

Some view this as a bicoastal issue - of course the rental market is tight in Silicon Valley or New York City. Unfortunately that is not the case. Here are the vacancy rates in Ohio and Michigan for example.

Limited apartment construction activity is clearly taking place around the country, particularly in major cities. However, just as the case with new houses and condos, rentals are being built for "high-end" clients. In most major cities, new rentals cost materially more than the average for those markets.

Source: WSJ

At the same time wage growth in the US remains subdued. In spite of a slight improvement last month (to 2.3% YoY), rental costs continue to rise faster than wages. The chart below describes the situation over the past five years.

This leaves an increasing number of households "behind", with millions more now spending over half of their income on rent. Unless construction ramps up materially over the next five years, the gap in the chart above will widen to crisis levels, putting significant pressure on family formation, raising homelessness, and dampening economic growth.


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